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Here's an example:

Say I own stock in a company that has future growth prospects of 30% year-over-year in free cash flows. That would be considered outstanding growth. Now if the present value of a stock is the present value of future cash flows, its price already has that growth rate factored into it. In other words, my stock would not appreciate unless the company exceeded the growth rate of 30%, correct?
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Now if the present value of a stock is the
present value of future cash flows, its price already has that growth rate factored into it. In other
words, my stock would not appreciate unless the company exceeded the growth rate of 30%,
correct?


It seems to me, that you are mixing intrinsic value (determined by calculating the present value of future cash flows) with price ( the market place's popularity contest). The current price may be at, below, or above the calculated value of the business, and often is. That is the reason I do DCF analysis.

An example is CSCO. This year it has been as low a price as $51, my FV/sh came out in the range of 41-57, since I had been wanting to acquire CSCO for my port. I bought at $51 ( actually hit at 53 as it started back up rapidly). It is now 63 or so and I would not normally buy more until it is again below my calculated FV/sh.

The FV/sh is the last step in my deciding to buy a company. I think it is a flawed procedure but....

Bruce
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It seems to me, that you are mixing intrinsic value (determined by calculating the present value of future cash flows) with price ( the market place's popularity contest). The current price may be at, below, or above the calculated value of the business, and often is. That is the reason I do DCF analysis.
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Isn't DCF, discounting the future cash flows to the present, the same as how you defined instrinsic value?
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sn't DCF, discounting the future cash flows to the present, the same as how you defined instrinsic
value?


And herd, fearing that he has perhaps confused the issue, replies, "Yep". Intrinsic Value, Fair Value, and DCF Value seem to be about the same as I understand them. Some folks use different methods to arrive at their DCF/Intrinsic/Fair Value, but I think all of us are comparing a calculated value based on future earnings to current market pricing.

The key point here is that market pricing (contrary to EMT) may or may not reflect the future earning potential of the business in question.

Bruce
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Say I own stock in a company that has future growth prospects of 30% year-over-year in free cash flows. That would be considered outstanding growth. Now if the present value of a stock is the present value of future cash flows, its price already has that growth rate factored into it. In other words, my stock would not appreciate unless the company exceeded the growth rate of 30%, correct?

If you believe in EMT, then this is correct. If you're a value investor, then you might believe that identifying the times when this is not correct (a price that doesn't match the DCF value by a significant margin) and making trades accordingly would be a Good Idea.

-Richard
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Most experts agree that the market is semi-strong efficient, especially in these days of near instant access to news. That being said, it would indicate a need to find a company that is not only growing, but growing at an ever increasing rate as surprise news.
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Most experts agree that the market is semi-strong efficient, especially in these days of near instant access to news. That being said, it would indicate a need to find a company that is not only growing, but growing at an ever increasing rate as surprise news.

Oh, come on now. Most experts couldn't agree with each other on basic issues like the weather, let alone EMT!

Take AEOS for example (one of my larger current holdings). How is it 'worth' 9% more today that it was yesterday at the same time, if the company hasn't changed? It costs ~20% of what it did less than a year ago -- has it really changed that much? If not, how can both prices be correct?

-Richard
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Most empirical studies suggest that the stock market is highly efficient in the weak form and reasonably efficient in the semistrong form for the larger and more widely followed stocks. That is not to say there are not exceptions, especially with the smaller, lesser-known stocks. I would suspect with the growth of the internet, even finding those good deals among smaller companies will become more difficult. Also, most studies show that markets are not strong-form efficient, so if you know something from the inside, abnormal profits are possible.
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I would suspect with the growth of the internet, even finding those good deals among smaller companies will become more difficult.

Personally, I believe that as more people take a more 'active' role in their investments the swings will remain as inane as ever, but the frequency (or the distance between the peaks) will decrease. Possibly this will give rise to a new breed of value-oriented daytraders? I shudder to think...

-Richard
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What's been missed in the replies I've read so far, is that the DCF calculation includes a discount rate, which is the same as your required rate of return. The PV figure one gets, then is, in theory, a number that assures you that a worthwhile rate of return is at least theoretically possible, assuming your projected rates of earnings and free cashflow growth are met or exceeded.

That being the case, it is prudent to give yourself a generous discount rate, and being very conservative about the growth you need a company to show in order to prove a worthwhile investment in the long run.

You, of course, get to decide what that rate of return should be, but most people set it as the sum of a risk-free return and a premium one finds acceptable for taking the risk of holding equities, rather than treasuries or some other relatively low-risk form of security. My discount rate is usually 15 to 19 percent, but is reevaluated when other long-term rates change.

On the risk-free return, the 30-year treasury rate is often suggested as a proxy, but considering the weirdness with the 30 year, should probably be set to some other benchmark.
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Most experts agree that the market is semi-strong efficient, especially in these days of near instant access to news. That being said, it would indicate a need to find a company that is not only growing, but growing at an ever increasing rate as surprise news.

The markets have a history of pursuing near-instantanous news, going as far back as the earliest days of the telegraph. No question that news has gotten better, but so has rumor and falsehood.

A recent case in point would be the analyst story about Cor Therapeutics that claimed their lead drug, Integrilin was less safe than ReoPro. By the next morning a flood of informed comments had flooded in from cardiologists and others to cut the analyst's interpretation to shreds, but the story *did* manage to take the stock down a significant percentage for the brief time it went unchallenged and unqualified.

While I would agree that one can do a considerably more thorough re-evaluation of a company based on its latest news today, compared to even 20 years ago, when spreadsheets were next to non-existant, and certainly not within the reach of the average common stock buyer, current price behavior suggests to me that this is *not* the sum total of what is happening, or at least, if it is, it is not reflected in current pricing levels, as those doing the analysis may not be either buying or selling.

One of my favorite concepts is "signal to noise ratio" when it comes to data and information. There is no doubt that new information moves individual stocks, and often whole sectors. At times it moves markets as a whole, sometimes for good reason and sometimes for reasons that are hard to deduce.

The question is, since a day's pricing for individual issues reflects only what the buyers and sellers on that day were willing to pay or accept, not a price that all holders of a stock would willingly accept, how much *does* the day's pricing reflect about the real intrinsic value of the companies being valued at the market, and how much does it reflect the degree to which those who choose to trade on news allow themselves to be swayed by momentary distractions and noise?

As for the second goal you suggest, that of sticking to only those companies *expected* to grow at an ever increasing rate, compared to estimates, wouldn't EMT argue that those expectations of excess growth would *also* be priced in? (Looking at current prices, relative to assumed indicators of intrinsic value for some of the best-known performers, I can certainly accept *that* notion fairly easily).

In a number of cases I cound mention, it seems that not only is the expectation of hypergrowth priced in, but so, at times, is an expectation of growth far in excess of anything current analysts projections expect, even at their most optimistic.

Which isn't to say the market is wrong about those companies. How can I tell the future?

But it does suggest there is considerable risk associated with buying the sort of story that is only a good investment *if* it manages to beat an already stunning rate of growth.

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I think the 10-year treasury is becoming the proxy of choice for the risk free rate.
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>>My discount rate is usually 15 to 19 percent, but is reevaluated when other long-term rates change.

On the risk-free return, the 30-year treasury rate is often suggested as a proxy, but considering the weirdness with the 30 year, should probably be set to some other benchmark.<<

If you are going to fudge from the ~6.5% to 15-19%, why bother quibbling about 0.25% fluctuations in the yield of the 30yr treasuries?

Personally, I prefer Hagstrom's interpretation of Buffett - discount at the riskfree rate, but demand a strong margin of safety. OK, I fudge a bit too - I take the rate of the company's most recent L/T debt [avg AAA to BB corp. rates depending on the size of the company, when there is no debt]. That's based on the hazy notion that a banker would include enough of a premium to offset serious threats to cashflow.

-SkunkyBeer
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SkunkyBeer,

I once observed a banker at fairly close range as he was in the process of performing "due diligence" on a company that later came under serious SEC scrutiny for all manner of stock manipulation and and that seemed pretty fishy to me within moments of making contact with them. (I was consulting for someone other than the bank or the company in doubt at the time).

So I hope you'll forgive me if I don't immediately assume that bankers are always competent or prudent at assessing credit risks. It is somewhat reassuring to see one come forward to confirm what my calculations told me months ago about Amazon.com's convertibles, but such vigilence seems to be rather hard to come by in moments of extreme, widespread optimism.

You're right about 25 basis points. My rebracketing comes when prevailing rates shift by 75 basis points or more. And in the case of the 30 year, considering there's close to a 75 basis point gap between 3-10 year rates and the 30 year rate, and inversion not nearly so pronounced in yields outside of treasuries, it does make sense to look around for a benchmark that reflects what a 30 year risk free rate might be without treasury buybacks.

I would need to run some graphs to feel comfortable about projecting forward when it comes to using a risk free rate and *then* calculating a margin of safety. I've gotten used to using several of those percentage points as proxies for my minimum margin of safety. When I have time to run charts I'll take up what has been suggested by yourself and others here, and see what sort of benefit seems to come from considering things at more or less the risk-free rate.

Thanks for your thoughts.

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EB-

>>I once observed a banker at fairly close range as he was in the process of performing "due diligence" on a company that later came under serious SEC scrutiny for all manner of stock manipulation <<
Point well taken, though stock manipulation doesn't necessarily have to mean they were cooking the books. If they were, any value calculations based on the books are invalid, no matter what the discount rate. DD is only thing that will save you from that sucker's bet, not a 'value < price' revelation.

My other hangup about using 'my desired rate of return' to discount stocks is my desired rate is infinite - I just can't seem to find many values that way ;). Using a more objective discount rate at least puts all stocks on a level playing field. It also gives you a more objective test for judging whether a stock is overvalued - you don't have to wiegh your desired rate against Mr Market's. You can be more subjective when demanding your margin of safety - generally I shoot for 50%, but will go lower if the company is very predictable and the growth rate is very reasonable - take WDFC for example, I'm willing to accept a 25% margin of safety on something like that.

Regards -
-SkunkyBeer
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Dear EBlakemore,

Concerning Amazon convertibles. I assume you found out that they were overpriced, or did you come to another conclusion?

I haven't looked at them, I had assumed though that their value was the "convertible" part, not the coupon.

Lleweilun Smith
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Lieweilun,

I suppose "overpriced" is one way of looking at the convertibles.

What I felt, from looking at the numbers, is that they were trading at a price and effective yield that did not reflect my perceived risk on their balance sheet, even without trying to adjust my estimates for the several debatable accounting practices that many Amazon watchers have been pointing to for months, including the SEC.

Mostly a moot point, since at this point I would not want to assume the risks associated with buying either of the convertibles or the common. Apparently, though, there are/were those willing to assume those risks, even at relatively unattractive prices.

(Note: I haven't taken a second look at where the convertibles are trading post last week's bankruptcy risk predictions. For all I know they are reflecting more risk today than when I looked at them. I also haven't updated my Z scores for Amazon for a month or two, though I'll probably take a look again soon, just to see if anything is changing.)
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Say I own stock in a company that has future growth prospects of 30% year-over-year in free cash flows. That would be considered outstanding growth. Now if the present value of a stock is the present value of future cash flows, its price already has that growth rate factored into it. In other words, my stock would not appreciate unless the company exceeded the growth rate of 30%, correct?

Not really, for a few reasons.

1. The discount effect on a particular year lessens as time passes. Consider a zero-coupon bond due in 5 years, discounted at 6%. At issue date, the PV of that $1000 future payment is $747.26. Three years from now, the PV of that bond payment rises to $890.00 due to the passage of time.

2. As economic conditions change, the discount rate that people to analyze future FCF changes. This is part of the reason that stock prices tend to rise when interest rates stabilize or decrease, and tend to fall in a rising or uncertain interest rate climate like the last few months.

3. Changes that make the future estimates more or less reliable.

Mike
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